This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

The Oil Problem

Petroleum dependence poses economic and security threats.

The year 2012 became the second in a row to start with a run-up in oil prices. In 2011, the price of benchmark West Texas crude began to climb early and topped out at nearly $120 per barrel at the end of April. Oil inaugurated this year by climbing above $100 and reaching its highest level in eight months.

In general, oil prices have been quick on the upside. Following the global financial crisis, oil dipped only briefly and staged a prompt recovery, even though global economic growth remains sluggish. This has revived concerns that the world is running out of oil, which have been dormant since the 1980s.

Rising Demand

Indeed, over the past decade there has been a major increase in demand for oil. China in particular has been blamed for straining world supplies and driving up oil prices thanks to its extremely rapid pace of economic growth. China has slowed down recently, but its GDP still grew by a formidable 8.9 percent in the fourth quarter of 2011, with robust growth now coming from a much higher base.

Other large developing countries are also industrializing fast, and using more oil. Plus, China is now the world’s largest market for motor vehicles, with 14.5 million cars sold last year, or 2 million more than in the United States. In India, car sales are expected to reach 5 million in five years. Brazil, Indonesia, Turkey and Russia also have a large, and expanding, army of motorists. Collectively, these countries have more than 3 billion inhabitants, so their love for their set of wheels may spell trouble for global oil supplies.

Some analysts are predicting an era of very expensive oil, a global race to secure oil sources and even armed conflicts over oil.

Oil prices, however, are never a one-way bet. If past history teaches us anything about the oil market, it is that whenever analysts start predicting a sea of cheap oil (as they did in the early 1970s and again in the mid-1990s), it is time to prepare for a price hike. Similarly, when we start hearing about oil shortages (as we did throughout the 1970s and the early 1980s), it is a surefire sign that oil prices are on their way down.

Traders on the NYMEX derivatives market apparently have learned this lesson. They have been anticipating wide swings in oil prices. The second half of 2011 was marked by a sharp increase in new out-of-the-money option contracts, which would become profitable if oil rose into the $130-155 range or fell in the $45-60 range by end-2012. During the second half, the number of such contracts jumped by around 30 percent.

A plausible case may be made for a coming oversupply of oil, especially since current prices in the $80-100 range make many exploration and production projects economically viable. Even amid political controversy over the Keystone XL pipeline, new technology allows commercial extraction of oil from Canadian shale sands, making Canada a world leader in terms of oil reserves. New offshore discoveries have been made off the coast of Brazil, in the South China Sea and on the Arctic Shelf, while new technologies make deep sea drilling possible.

Natural gas, meanwhile, which can replace oil in energy production, traded in mid-January at its lowest price since 2002, thanks to the hydro fracking technique used to extract gas from rock formations in New York and Pennsylvania, among other places. There have been new discoveries, as well, for instance off the Mediterranean coast of Israel.

Unreliable Suppliers

The problem with oil is not so much a shortage of supply as political instability among oil exporters. Last year’s run-up in oil prices was the result of the Arab Spring, a series of protests and revolutions which spread through the Arab Middle East and North Africa. This year, oil is on the move because of rising tensions with Iran and the threat by Tehran to shut down the Strait of Hormuz.

The Strait of Hormuz is the Achilles’ heel of the global oil market. The 30-mile-wide body of water is traversed by oil tankers carrying one fifth of the world’s oil supply, or some 17 million barrels of crude daily.

The strait is only the tip of the iceberg, as it were. Oil exporting countries are rarely paragons of democracy, peace, prosperity or political stability. Some are little more than failed states and others are ruled by strongmen and kleptocrats, which makes them powder kegs waiting to explode.

In 2011 one of them, Libya, went through a revolution, the final result of which is by no means clear. As 2012 opened, political protests were stirring in Russia, which along with Saudi Arabia is the world’s largest oil exporter, and in Kazakhstan, the No. 2 oil producer among former Soviet republics.

Economic hardship in Nigeria has led to gasoline price increases and a wave of protests. Oil producer Venezuela is the only major Latin American country to resist the democratizing trend, but its populist leader Hugo Chavez is not only battling cancer, but may soon be facing political unrest, as well, as he prepares to run for his third consecutive term.

Expensive Risks

There is clear evidence that oil prices contain a risk premium — a markup in price that reflects the risk that any of these major oil producers will experience a lasting disruption in oil output. Higher oil prices have already extracted a toll on the world economy, leading to a slower recovery from the 2008-09 economic downturn and undermining the already fragile economies in Western Europe.

There are other, hidden costs, too. For example, the world community has been too cautious in dealing with the Iranian nuclear enrichment program. Washington has been applying pressure on Tehran sparingly for fear of disrupting the global oil market, even though safeguarding the Middle East and the rest of the world against a nuclear-armed Iran is clearly a national priority.

The imperative to ensure a smooth flow of oil means that — even amid a fiscal crisis, the end of the Iraq War and the impending withdrawal of American troops from Afghanistan — there will be few, if any, savings in the defense budget. Washington has already made it clear that U.S. Central Command will continue to protect the Persian Gulf. The new military strategy outlined by President Obama in early January, will rely less on boots on the ground, but will instead enhance U.S. air and naval capabilities and will shift attention toward the Asia/Pacific region.

In particular, additional U.S. troops are being sent to Australia, and other steps are being taken to make sure that China doesn’t bully neighbors or appropriate the lion’s share of the oil beneath the South China Sea.

The military effort to protect oil production and shipping routes will remain important, but it is costly, open-ended and, in the end, ineffective. The spike in oil prices on tensions with Iran is a case in point. While the Pentagon will probably be able to keep Tehran from disrupting the transit of tankers through the Strait of Hormuz or damaging oil facilities along the Persian Gulf, oil prices are likely to remain elevated on the mere possibility of a military conflict.

Rumors of a prospective U.S. or Israeli strike against Iranian nuclear facilities are already putting upward pressure on oil prices. This could tip the euro-zone into recession, bringing a collapse of the currency union and a new global downturn.

It should be seen as matter of national economic security to invest into oil-saving technologies, such as all-electric vehicles, substitute nuclear power and natural gas for oil and develop a wide range of alternative and renewable energy sources. Barring a rapid democratization of global oil exporters — an unlikely prospect, to be sure — ending dependence on oil remains an urgent priority to which the U.S. and its allies should devote considerable resources.

Sign up now—it's Free!

Sponsor Showcase

ThinkAdvisor's TechCenter is an educational resource designed to give you a competitive edge by keeping you abreast of new tech innovations and need-to-know information that can be applied to your business.

Featured Video

At Prudential Advisors, we're dedicated to helping all our clients get on the path to achieve their goals."Prudential Advisors" is a brand name of the Prudential Life Insurance Company of America and its subsidiaries